The Economy: My Take

Ok, here's my take on why the economy is in the state it's in. This is going to be a long one, so bear with me.

First of all, all markets cycle. The Dow Jones ran up to over 14,000 points before it came crashing down. If you look back at the 100 year history of the Dow Jones, you'll see that it has never, and will never sustain growth indefinitely without corrections. After a major run up, it must correct in order to charge itself for the next run up. So, after the run up from 7591.93 in mid-2002 to over 14,000 earlier this year, it was time for a downward correction.

Just in time for the needed correction, as one of the commenters to my last post astutely pointed out, there was something called "subprime lending" going on. This is where banks were making loans to people who couldn't possibly afford to pay such loans back. The greed that fueled the subprime lending mess is no different than the greed that fueled and sparked the dot com bust. In that case, people were pouring money into stocks of companies who had never seen a profit. When people finally started to figure out just how over-valued those companies were, it sparked a huge sell off (see Enron for further evidence of how this works).

But, before we place full and sole responsibility on the banks for causing this mess (and they do deserve a big portion of the blame), let's take a look at some other factors that were in play. In 1977 (Carter administration), Congress enacted the Community Reinvestment Act ("CRA") which "encouraged" banks to meet the credit needs of those living in the communities in which the banks took deposits. Click here for a good article explaining what happened. I put "encouraged" in parentheses because federal banking regulators could delay or prevent banks from merging, opening up new branches, and most other business-growth oriented tasks if it was found the banks were not making enough CRA loans. The reasoning behind the CRA was to prevent or discourage discriminatory practices in lending. Who else, besides me, thinks it's absurd that a bank would pass up a profitable lending opportunity simply because of race, ethnicity, etc? Banks typically pass on such "opportunities" because they are too risky.

So anyway, suddenly the world of home-ownership was opened up to millions of people who didn't have access to such large loans before,and for good reason. Banks began making the loans, but in order to protect themselves, would create loan terms that were not very favorable to the borrower, such as Adjustable Rate Mortgages ("ARM"). This allowed a borrower to borrow money at a low rate, only to see that rate fluctuate with the market. It also allowed the borrower to borrow a heck of a lot more money that he or she could afford. When the rates starting moving up, these people could no longer afford their mortgages and didn't have enough equity in their homes to refinance on more favorable terms.

Now with millions more potential homeowners out there, development and construction took off. Builders were selling homes quicker than they could build them. All the while, Fannie Mae and Freddie Mac were bundling these subprime loans into investment packages and selling them off to investors. With essentially no obstacles to the ability to borrow money, housing prices skyrocketed creating what you hear on the news every day--a housing bubble. Any time you hear the word bubble in connection with the world of finance, it usually indicates that something's value is severely overblown. (see also "tech-bubble").

What do bubbles do when the get too big--they burst. When millions of people began defaulting on 10s of billions of dollars in home loans, banks began going out of business because the homes securing those mortgages were not worth as much as the outstanding loan principals. Investors who bought the loan packages began going out of business because their investments were worthless. Companies (Fannie Mae and Freddie Mac) who made a large percentage of their money selling the loans found themselves without buyers, and therefore without a market in which to sell their crappy loans. So, in comes the government with $700 billion to rescue everyone...or at least the ones it wants to rescue. Can you explain to me why the government bailed out Fannie Mae and Freddie Mac, but let Lehman Brothers go bankrupt? Hmmm....

So, now there are lots of businesses out there that can't borrow money because the banks don't have any money to lend. Some businesses, especially small businesses, rely on lines of credit in order to maintain payroll and keep inventory rolling through their businesses. Want to venture a guess as to what type of large expense a business will cut when it needs to shore up cash flow? That's right, payroll! So all of a sudden, thousands upon thousands of people start losing their jobs.

So, if you want my opinion on who or what is responsible for this financial crisis, here you go (in no particular order):

1. The federal government forced banks to make loans to subprime borrowers based on the mantra that everyone deserves to own a home, regardless of whether you can actually afford it.

2. Banks were somewhat forced to make bad loans, but let their own greed fuel the fire, causing an explosion no one can control.

3. People agreed to loans so large that even a 5th grader would know it wouldn't be paid back. If you make $400 a week, you should know you can't afford a $200,000 loan, even if the bank agrees to lend you that much.

4. Investors who allocated large percentages of their portfolios to buying these risky loans have gone belly up.

Who is left holding the bag with no hope of being "bailed out"? All of us who are responsible with credit and are paying off our mortgages on time. We continue with the same obligations we agreed to while those who were grossly irresponsible are either bailed out by the government or by the bankruptcy process. How's that for encouraging responsibility?